Eurozone risks rising as outlook darkens

Investors want to believe eurozone policymakers can resolve the debt crisis. But the risk of a prolonged recession is rising, and with it the chances that more action will be needed to shore up the currency area.

A full 86% of fixed-income investors surveyed by Fitch Ratings said the European Central Bank's commitment to buy bonds of troubled eurozone nations, and European Union's plans for a banking union represent major positive steps, although 81% acknowledged "significant economic, financial and political risks remain."

Private forecasters think the European Commission is overly optimistic in its view that the eurozone will return to growth next year, after contracting by 0.4% in 2012, as deep spending cuts and tax rises take effect.

A weaker-than-expected performance would undermine those and other assumptions underpinning bailout programs in Greece and Portugal. It would also pile pressure on Spain to seek a formal bailout and further hobble core economies, such as France and Germany.

"The view embodied in our forecast is essentially that 2013 is going to be another extremely challenging year," said James Nixon, economist at Societe Generale, which sees the eurozone economy shrinking by 0.3% next year.

"The governments of Greece, Spain and Italy have embarked on multi-year consolidation programmes and next year is the second of three," he said.

"We're already in the (fiscal) cliff this year and there is further fiscal tightening to come in 2013," said Marie Diron, director of macro forecasting at Oxford Economics.

Spending by governments on goods and services, which has a direct impact on economic activity, would fall by 0.8%, compared with just 0.1% in 2012, Diron said, pointing to cuts in Spain and Italy that have not yet been implemented.

Buffett: Eurozone may not survive

Southern Europe's woes have already begun to affect the core. Germany has seen growth slow, and Moody's stripped France of its AAA credit rating Tuesday, citing its exposure to shocks from the eurozone periphery.

Reaction was muted -- the euro dipped and French government bonds were broadly stable -- but Moody's warned that any further deterioration in France's economic prospects or ability to implement reform could trigger another cut.

The downgrade could presage cuts for those top-rated countries, said Steven Englander, global head of G10 FX Strategy at Citi(C).

"Little of what they cite is new and the downgrade reflects a reality that has probably long applied to France and applies to a number of the remaining AAA countries as well," said Englander.

Germany, the Netherlands and Austria are feeling the effects of the eurozone slowdown and like France, are also funding existing bailouts.

Market nerves were calmed in September when the ECB announced its bond-buying program. The program, known as outright monetary transactions or OMT, requires governments to seek a formal bailout first.

Spain, which has already received pledges of support to recapitalize its banking system, has held off asking for a bailout but has a mountain to climb in 2013 to meet its fiscal targets.

"The government's plan so far seems to have been to wait-and-see and it is unclear why this should change unless markets were to sell off more broadly or economic activity to fall even more sharply, creating a stronger sense of urgency," UBS FX strategist Beat Siegenthaler said in a note.

"The risk of a broader sell-off has certainly increased over recent weeks as the OMT-induced rally has run its course and, apart from a favorable Greek review decision, there seems little on the policy horizon in terms of supportive events," he added.

Underscoring the challenges facing southern Europe, Moody's also kept a negative outlook on Italy's banks, and said the ratio of problem loans was rising faster than it expected, driven by the impact of the recession on companies.

"This trend shows no sign of abating; combined with bank deleveraging and a corresponding contraction in the supply of credit, further pressures on asset quality are inevitable," the agency said.